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The Primary objective of central banks is to maintain economic stability; it is desirable because it encourages economic growth that uplifts employment level and prosperity. To achieve higher & stable economic growth, central banks use monetary policy in which money supply and inflation rate is controlled and set at desired level by adjusting short-term interest rates. While achieving these objectives: “higher, stable economic growth”, “low, stable inflation” and “stable interest rates”, central banks often face tradeoff between them. So, Central banks have to design policy according to the prevailing economic situation. When the economy is at “Boom Phase” it is characterized by higher business activities, higher income, higher spending, higher employment and higher economic growth. On the other hand “Recession Phase” is characterized by business cycle downturn, low investment, low production, low income, low spending, higher unemployment, low economic growth. Monetary policy makers review economic and financial situation of the country and decide whether to adopt expansionary monetary policy or restrictive monetary policy to achieve their long term goals: economic growth and prosperity.

Question1:

Discuss the relationship between short-term interest rates and inflation. How changes in interest rates affect money supply and inflation?

Question 2:

If the economy is experiencing business cycle downturn, which one of the two discussed policies will be adopted by monetary policy makers and how it helps the economy to recover from recession?

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Replies to This Discussion

ANSWER 1 :::::

tHE “liquidity effect” plays a central role in Keynesian theory ofthe transmission of monetary policy. It is based on the notion that the demand for money is negatively related to the nominal interest rate.1 Other things the same, an exogenous increase in the money stock depresses nominal and real interest rates, stimulating aggregate demand. Even though theorists acquiesce to the liquidity effect as a theoietical proposition, it is often challenged on efficacy grounds. It is argued that changes in the money stock do not leave all other things unchanged. Monetarists, such as Friedman (1968) assert that the liquidity effect is, at best, only temporary; the ultimate effect of more rapid money growth is higher inflation (or, mom-c importantly, expectations of higher- inflation) and, consequently, higher nominal interest rates. New classical economists argue that the real interest rate is determined by basic tastes and technology considerations, which are slow to change.’ If increases in the money supply primarily affect the market’s expectations of inflation, nominal interest rates will rise immediately.

ANSWER 2 

choose expansionary monetary policy 

policy by monetaryauthorities to expand money supply and boost economic activity, mainly by keeping interest rates low to encourage borrowing by companies, individuals and banks.

MGT411 - Money & Banking GDB No. 2 Solution Fall 2015 Due Date Monday, January 25, 2016

MGT411 - Money & Banking GDB No. 2 Solution Fall 2015 Due Date Monday, January 25, 2016  

Total Marks 5
Starting Date Thursday, January 21, 2016
Closing Date Monday, January 25, 2016
Status Open
Question Title GDB No. 2
Question Description

GDB-2

Money & Banking students will be able to understand:

  • Importance of Monetary policy in achieving Central banks’ objectives
  • Trade-off between different goals of monetary policy
  • How to design the most appropriate monetary policy according to the prevailing economic situation

 

Scenario:

The Primary objective of central banks is to maintain economic stability; it is desirable because it encourages economic growth that uplifts employment level and prosperity. To achieve higher & stable economic growth, central banks use monetary policy in which money supply and inflation rate is controlled and set at desired level by adjusting short-term interest rates. While achieving these objectives: “higher, stable economic growth”, “low, stable inflation” and “stable interest rates”, central banks often face tradeoff between them. So, Central banks have to design policy according to the prevailing economic situation. When the economy is at “Boom Phase” it is characterized by higher business activities, higher income, higher spending, higher employment and higher economic growth. On the other hand “Recession Phase” is characterized by business cycle downturn, low investment, low production, low income, low spending, higher unemployment, low economic growth. Monetary policy makers review economic and financial situation of the country and decide whether to adopt expansionary monetary policy or restrictive monetary policy to achieve their long term goals: economic growth and prosperity.

 

Question1:

Discuss the relationship between short-term interest rates and inflation. How changes in interest rates affect money supply and inflation?

 

Question 2:

If the economy is experiencing business cycle downturn, which one of the two discussed policies will be adopted by monetary policy makers and how it helps the economy to recover from recession?

 

 (Support your answers with logical reasoning)

 

Note: Complete your comment within 150 words

 

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MGT411 gdb idea solution

 There are 2 theories to explain the relation between inflation and economy.

o Demand-pull theory:

o

* Lesser Interest rates will attract lesser savings. So, people tend to spend more when the interest rates are less. Thus creating more demand for goods and services.

* Lesser Interest rates will encourage people to borrow more money/ So, again people tend to spend more borrowed money when the interest rates are less. Thus creating more demand for goods and services.

* When supply of goods and services is less than the demand, prices go up. This also results in inflation.

o Cost-push theory:

o

* When the cost of the raw materials and inputs increases, the cost of endproducts also increases. This rise in cost of goods and services pushes the price higher resulting in higher price.

In a healthy economy, Inflation and Interest rates move hand in hand as shown in graph below and are mutually dependent on each other.

* Like we discussed in demand-pull theory, Lower interest rates put more borrowing power in the hands of consumers. And when consumers spend more, the economy grows, naturally creating inflation.

* If the central bank decides that the economy is growing too fast (which is a bad sign in the long term) using indexes like consumer price index (CPI),wholesale price index (WPI), They will try to minimize the effect of it by increasing the interest rates and vice versa.

* This rising interest rates in turn will encourage people to save more and borrow less thus reducing the amount of money in circulation in the market. Lesser money in the market makes it difficult to buy the goods and servicesthus slowing down the rise in price.

* In short, A stable economy is a healthy economy with right wages and less unemployment.

Relationship: In general, as interest rates are lowered, more people are able to borrow more money. The result is that consumers have more money to spend, causing the economy to grow and inflation to increase. The opposite holds true for rising interest rates. As interest rates are increased, consumers tend to have less money to spend. With less spending, the economy slows and inflationdecreases.

Answer-1

The “liquidity effect” plays a central role in Keynesian theory ofthe transmission of monetary policy. It is based on the notion that the demand for money is negatively related to the nominal interest rate.1 Other things the same, an exogenous increase in the money stock depresses nominal and real interest rates, stimulating aggregate demand. Even though theorists acquiesce to the liquidity effect as a theoietical proposition, it is often challenged on efficacy grounds. It is argued that changes in the money stock do not leave all other things unchanged. Monetarists, such as Friedman (1968) assert that the liquidity effect is, at best, only temporary; the ultimate effect of more rapid money growth is higher inflation (or, mom-c importantly, expectations of higher- inflation) and, consequently, higher nominal interest rates. New classical economists argue that the real interest rate is determined by basic tastes and technology considerations, which are slow to change.’ If increases in the money supply primarily affect the market’s expectations of inflation, nominal interest rates will rise immediately.

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